Giant Interactive Q3 2007 Earnings Call Transcript

Nov.20.07 | About: Giant Interactive (GA)

Giant Interactive Group Inc. (NYSE:GA)

Q3 2007 Earnings Call

November 20, 2007 8:00 am ET

Executives

Yuzhu Shi - Chairman of the Board of Directors, ChiefExecutive Officer

Wei Liu - President, Director

Eric He - Chief Financial Officer

Analysts

Eddie Leung - Merrill Lynch

Benjamin Schachter - UBS

Ken Kim - Merrill Lynch

C. Ming Zhao - Susquehanna

Jerry Sullivan - American Century

George Chu - UBS

Alicia Yapp - Citigroup

Defan Jian - City Capital Assets Management

Charles Ho - CAVA Capital

Operator

Welcome to the Giant Interactive Group Incorporated thirdquarter 2007 results conference call. Before we continue, I would like toremind you that all statements on this call that are not strictly historical innature constitute forward-looking statements. Such statements include, but arenot limited to, statements about the development of ZT online expansion pack,ZT online PTP and Giant online, and King of Kings 3, and our anticipatedresults of operation. Such forward-looking statements involve known and unknownrisks, uncertainties, and other factors that may cause the actual results ofGiant to be materially different from historical results or from any resultsexpressed or implied by such forward-looking statements. These factors include,but are not limited to, risks and uncertainties related to the progress,timing, cost and results of game testing and product development competitionfrom the other online game companies, and the additional risks discussed in thefilings with the Securities and Exchange Commission. All forward-lookingstatements are qualified in the entity by cautionary statements and Giantundertakes no obligation to revise or update this information to reflect eventsor circumstances after the date hereof.

I would like to now turn the call over to your host fortoday, Mr. Eric He, Chief Financial Officer of Giant Interactive Group. Pleasego ahead, sir.

Eric He

Thank you, Operator and good morning, everyone. Thank youfor joining us for our third quarter 2007 results conference call, our first asa public company. Joining me today are Mr. Yuzhu Shi, Giant Chairman and CEO;and Ms. Wei Liu, our President. As we proceed through our prepared remarks, wewill refer to our result presentation, which can be downloaded from our websiteat www.giantig.com. Following the remarks, Mr. Yuzhu Shi, Ms. Liu and I will behappy to take your questions.

2007 has been an exciting year for Giant, marked by a numberof key milestones; most importantly, our IPO and NYSE listing on November 1,2007. A brief overview, which is provided on slide 4, our listing was amilestone event on a number of fronts, as we were the largest IPO from aChinese entrepreneurial company to have gone public in 2007 and the firstInternet online game company from China to list on the NYSE.

Before moving to the results for the quarter, let me beginwith a brief overview of Giant, starting on slide 5, for the benefit of thoseof you that may be new to our company.

We are a leading developer and operator of online games inChina, focusing on MMORPGs and creator of ZT Online, China’s most popular gameas voted by players in 2006, according to a report published by IDC.

We have witnessed strong growth since the launch of ZTOnline, which reached over 1 million peak concurrent users in the secondquarter of 2007 and has net revenue growth of 164% year over year for the thirdquarter of 2007.

Driving this growth has been our passion for games, which isa key component of our corporate culture and fuel of strong product developmentand technological capabilities. Together with our extensive marketing anddistribution infrastructures and deep understanding of Chinese mass markets, wehave established a strong base for the development of future games.

Let’s now look at some of the key operational developmentsfrom the quarter, starting on slide 6. ZT Online is currently our primaryrevenue driver and continued to achieve strong growth and acclaim since itslaunch in 2006. That said, our third quarter 2007 ACU and PCU have declinedslightly on a sequential basis, as we institute a change in our game rule todiscourage gold farming activities in June 2007.

However, in an effort to maintain ZT Online’s leadershipposition in the market, we continue to release new content and features intoour games. As part of this effort, we launched ZT Online’s fourth expansionpack in July 2007 and as a result, we believe that our player interactivityoptions will greatly enhance within the game, as well as player loyalties tothe game. In addition, we have witnessed improving ACU and PCU figures eachmonth during the third quarter of 2007.

We believe that as a result of the market acceptance of thisexpansion pack, and as noted on slide 7, we saw an 88% year over year increaseand a 3.3% sequential growth of active paying accounts, or APA, from the secondquarter of 2007, resulting in a 1.3 million APA for the third quarter 2007.

Our APA increased every quarter in the last seven quarterssince ZT Online’s commercial launch. In addition, ARPU shows strong growth,increasing 38% over the third quarter 2006 and 5.6% sequentially quarter overquarter to RMB305, approximately $41.

As noted on slide 8, the next expansion pack for ZT Onlineis slated to be launched toward the end of the fourth quarter. This expansionpack is expected to greatly enhance the geographical and dimensional interactiveexperience of our players.

Another addition to our product portfolio is ZT Online PTPversion, in which players are able to purchase playing time but not virtualitems. We currently launched ZT Online PTP and we believe this new offeringwill likely capture a niche market and will deepen our market penetration. Sofar, we are making good progress.

Giant Online is our highly anticipated new game with over150,000 daily volunteer playing players currently having participated in theclosed beta testing, which reached over 30,000 concurrent users. Giant Onlinehas already been commercially launched in the fourth quarter of 2007 and theresponses thus far have been very positive. We anticipate to start ramping upusers by the first quarter of 2008.

Looking farther out, we expect to launch King of Kings 3, afree-to-play fully 3D MMORPG in the second quarter of 2008.

As shown on slide 9, a key component of our growth strategyis our distribution and marketing efforts aimed at expanding our reach beyondthe major metropolitan centers and larger cities, and into the under-penetratedmedium and smaller cities.

Several macro trends also noted on slide 9, includingincreasing urbanization, household income, as well as limited entertainmentoptions in these regions provide us with the opportunity to tap into a largeplayer base that is willing and able to pay and display a high level of playerloyalty. These characters will translate into huge market potential.

To reach this large untapped market segment, we have beenbusy expanding our nationwide marketing and distribution network, highlightedon slide 10. As part of this expansion in the third quarter, we added anadditional 1,200 sales liaison personnel, bringing our total to 3,500 as ofOctober 1, 2007.

In addition, we added 220 new liaison offices during thethird quarter, so now we have over 470 liaison offices as of September 30,2007. Our goal is to maximize player awareness and recognition of our games,which in turn resulted in greater market penetration.

Now, let’s move on to an overview of our financial resultsfor the quarter. I will provide a summary of key financial highlights for thethird quarter and the nine months ended September 30, 2007. A summary of theseresults can be found on the slide 12 to 15 of our presentation.

On slide 12, you can see both our top and bottom linehighlights. Year over year, total net revenue were up over 164% to RMB405.2million, or $54.1 million. This increase is mainly attributable to an increasein online game net revenues, which grew more than 163% to RMB404 million, or$53.9 million. ZT Online has maintained a solid customer base, largely due toour continual product enhancement efforts, resulting in a solid quarter afterquarter revenue growth.

Net income was up over 152% year over year to $290.2million, or $38.7 million.

We are also pleased to report an increase in gross profit,which grew more than 153% to RMB359.8 million, or $48 million, over thirdquarter 2006.

Our margins remained very strong, as you can see on slide13. Gross margin decreased slightly due to our increased investment to developour infrastructure in preparation for the launch of our new games and expansionpacks.

On slide 14, you can see that our operating expenses for thequarter totaled RMB70.2 million, or $9.4 million. Included in our totaloperating expenses were RMB7.2 million in R&D expenses that went towardhiring new employees to aid in the development process of our new games.

RMB59.6 million in sales and marketing expenses which wereused to help expand our marketing campaign throughout almost every province ofChina, including an increased focus on the medium and smaller cities, andRMB20.1 million in general and administrative expenses.

As we continue to grow and expand our business, we aremaking a conscious effort to control costs and optimize our efficiencies. Wehave no income tax expenses to report for this quarter as we are currentlystill experiencing a tax holiday.

Cash and cash equivalents at the end of the third quartertotaled RMB1.171 billion or $156.1 million. We currently have a sizable cashbalance of approximately RMB6.8 billion, or $905 million, including proceedsgenerated from our IPO, which we intend to use towards the continual growth ofour business, including financing capital expenditures and funding of futureacquisitions to further accelerate our growth.

With our established track record, focused strategy andsolid operational foundations, we are confident in our ability to realize ourgoal of becoming the largest online game developer and operator in Asia.

Thank you for your time. We are happy to take yourquestions. Operator, please begin the Q&A session.

Question-and-AnswerSession

Operator

(Operator Instructions) Your first question comes from the line ofEddie Leung, Merrill Lynch. Please proceed.

Eddie Leung - MerrillLynch

Good evening. Good quarter. I have a couple of questions.The first question is could you elaborate a little bit more on the trend ofyour ACU and PCU throughout the third quarter, as well as if you [made a chart]about some of the initial trends that we see in the fourth quarter to addresssome of the concerns from some people.

Number two, could you also talk a little bit about thefeedback that you get from users during the closed beta testing for your newgame, Giant? Thank you.

Eric He

Thank you, Eddie. I will direct this question to Ms. Liu,our President. Ms. Liu, please.

Wei Liu (Translation)

Eddie, I will address your first question first, in terms ofthe trend of the ACU and PCU in our third quarter. As we know, in the secondquarter ’07 our ACU and PCU numbers actually reached a high point. In the thirdquarter, the beginning of the third quarter, we are seeing a slight dip interms of these two numbers. The reason is really because we introduced a changein one of the game rules to discourage gold farming activities we are seeingand that actually caused the ACU and PCU number to dip. However, we believe thechange is beneficial in terms of the company’s long-term growth.

In July, we actually released the expansion pack. It’scalled Zhong Zhi Cheng Cheng. We are happy to witness an improving ACU and PCUnumber. Up until now, our PCU number has come back up until about 900,000concurrent users.

In addition, I would like to point out two other very keyparameters. One is called active player players, APP. We are seeing thecontinuous improvement in this number. In the third quarter, this numberactually has reached up to 1.3 million users and that represents approximately5.6% of increase compared to last quarter.

The second important parameter is of course the ARPU valueand we are seeing in the third quarter this number actually increased for morethan 3%, about 3.3% compared to the second quarter.

Eric He

Now I would like to direct the second part of the questionto Mr. Shi, the feedback on the preliminary feedback on Giant Online.

Yuzhu Shi (Translation)

To address the second question in terms of the feedbackcoming out from the closed beta testing of Giant Online, I think so far we havebeen receiving very positive feedback from those testers.

Currently we are undergoing this dual closed beta testing.We expect to start the official closed beta testing beginning next month. Eventhough currently we don’t view ACU/PCU parameters as sort of key indicators ofwhether the game is going to be successful or not just yet, we are happy to seemore than 400,000 concurrent users in the game already and also, we’ve actuallyseen volunteers reaching up to 150,000 concurrent users. So far, the feedbackfrom all those users has been very positive.

So far we have managed to build in a few dozen, more than afew dozen innovations into the game and we believe with the continuousintroduction of more innovative ideas and rules or functions, we will receivebetter feedback from the user.

Starting in next quarter, we’ll start open beta testing andwith that, we expect to have put in more resources in terms of launching andexperimenting the game and until then, we will expect to have much more userbase or much more feedback coming out from this pool.

Compared to the initial feedback, the closed beta testingfeedback from this user pool from Giant Online compared to that feedback we gotfrom ZT Online, we actually have seen a much better feedback from the user.

Eric He

Next question, please.

Eddie Leung - MerrillLynch

Yes, thank you, Eric. (Translation not available) Thanks.

Operator

Your next question comes from the line of Ben Schachter fromUBS Securities. Please proceed.

Benjamin Schachter -UBS

Good evening and congratulations on your first quarter as apublic company. First question, I was just wondering if you could talk about,should we expect any revenues in 4Q from Giant Online or ZT PTP?

The second question, I was wondering if you could justclarify what the line item in the expenses under government incentives, whatthat represents.

And then finally, I was wondering if you have any commentson concentration of revenues around the top 20% and the top 5%, if that’s anumber you can give us and where we should expect that to go over time. Thanks.

Eric He

Sure. Let me answer your questions. As we said it in theprospectus, Giant Online and ZT Online PTP both are actually commercial launchin this quarter, meaning that we start collecting revenue for those two games.However, their contribution, their revenue contribution in the fourth quarterof this year is very minimal, because as you know, we just introduced a game tothe public and also because accounting principles can recognize very little, asmall percentage of the revenue.

The second question is regarding the government incentive.That government incentive in fact is a refund of our business tax. Thatbusiness tax actually was and has been a deduction of our revenue, meaning thatit’s been put in as a cost of services. So on a recurrent basis, every thirdquarter of the year, we will receive a refund of government refunds on thatbusiness tax. So it happens in the third quarter of ’06 and it also happened inthe third quarter of ’07, so according to accounting principles, we will have toinclude that into our operating expenses, the deduction of operating expenses.So that is the nature of the government incentive.

The third one is the revenue. The revenue concentration,actually we haven’t seen too much differences. As we mentioned before, the top5% of the -- the top 20% of the paying accounts account for 80% of the revenueand the top 5% accounts for about 50% of the total revenue. I think thatrevenue mix is still pretty much hold true for the third quarter, so we haven’tseen too much of changes in that mix yet.

Benjamin Schachter -UBS

And then the final question is ARPU into 4Q, should weexpect that to go up or down?

Eric He

Ben, that’s a tough question. As you know, ARPU is acombination of revenue and active paying accounts, or active paying users. Nowit’s in the middle of the fourth quarter. It will be very difficult for us toforecast what is the final result of ARPU in the fourth quarter. All we can sayis, as Ms. Liu mentioned, that our ACU number actually has been progressingvery well and the feedback from Giant Online has been very positive, somanagement is very confident on the outlook of the business and the company. SoI think an ARPU number, I cannot answer the question for the time being at thismoment, but we are very confident on the prospect of the company and thebusiness.

Benjamin Schachter -UBS

Thank you very much and congratulations again on your firstquarter as a public company.

Operator

Your next question comes from the line of [Ken Kim], MerrillLynch. Please proceed.

Ken Kim - MerrillLynch

Great first quarter. I just had a couple of questions withregard to first of all, the number of servers you now currently have for ZT.And you talk on page eight about Giant Online and the advanced server technologythat’s going to enable up to 1 million concurrent users. How many of thoseservers have you already prepared and what should we expect in terms of arollout for the number of servers per quarter?

And then the second question would be there’s talk of yourGiant Online potentially having a price cap. Obviously there’s some worrieswith regard to -- that this game might cost a lot of money for the user. Couldyou tell me if that’s just a false rumor out in the market, or you areconsidering during the beta testing of somehow limiting the amount of moneyspent by a user? Thank you.

Eric He

Okay, very good. Let me handle the first question and then Iwill pass the second question to Ms. Liu, our President, to talk about in termsof the Giant Online question. Let me just translate the second part, and thenI’ll answer the first part.

Let me answer the first question. In terms of servers, forZT Online, as you know it’s a huge mega-game. We actually have more than 1,700servers around the country to service our customers. Our goal is to provide astate-of-the-art service to our users, so we constantly are adding or replacingour servers along the way.

As to your question regarding the Giant Online, the servertechnology, yes, we have a very unique server technology which will allow morethan 1 million players playing in a single shot and we are actually ramping upthat server farms at this moment. It’s a clustering structures for the timebeing because as you can tell, the participants right now, it’s about 150,000and the concurrent user is in 30,000 to 40,000, so the number compared with ZTOnline still is not up to that scale.

At this moment, we are ramping up the servers for the timebeing. The percentage, the servers servicing the Giant Online, the percentageis not very high. I would say it’s only 5% to 10% of the 1,700 servers ascompared to the ZT that is currently in use.

Now I would like to refer the second question to Mr. Shi.Thanks.

Yuzhu Shi (Translation)

First of all, I just want to highlight that there is somedifference in terms of Giant Online and ZT Online. ZT Online actually focuses alot about establishing a hero or leadership in the game. It’s more aboutindividualism, while with Giant Online, we are promoting the teamwork spirit.

So in order to encourage the teamwork spirit, we purposelybuilt in the rule to limit each individual’s capability by implementing such arule, i.e. putting a price cap in terms of how much they can spend in the game.

In ZT Online, we are seeing 15% of people are paying usersor paying players, while 85% of remaining users are non-paying players. In theclosed beta testing phase of Giant Online, there is a much higher percentage interms of the paying players at a slightly lower ARPU value.

From current assessment, we believe that the average incomeor the revenue from Giant Online will not be lower compared to ZT Online.

Eric He

Did we answer your question?

Ken Kim - MerrillLynch

Yes.

Eric He

Okay, good. Next question, please.

Operator

Your next question comes from the line of Ming Zhao fromSIG. Please proceed.

C. Ming Zhao -Susquehanna

Thank you. Good evening. Congratulations on your recent IPO.(Translation not available) So my first question is what have you doneinternally and externally after your IPO?

Wei Liu (Translation)

The answer is yes, we have done quite a few work bothinternally and externally. The first thing we did is we organized a town hallmeeting, whereby we organized everybody to come in and remind them we are stilla young company and also we need to stay entrepreneurial. We actually have setnew targets in terms of performance for both ZT Online and Giant Online forevery employee, so all the team members, we know that we need to stay focusedand work together as a team towards the new goal.

Secondly, we actually formed a strategic development groupor department whereby this core group of people, their responsibility is tokeep identifying the earlier stage R&D, new ideas, innovations, and alsoM&A opportunities and strategic alliance opportunities.

Thirdly, in terms of licensing, we are actually engaging inactive dialog for discussions with overseas established players in this spaceto seek further collaboration opportunities.

C. Ming Zhao -Susquehanna

(Translation not available) My second question is what isthe reason for licensing King of Kings 3? Thank you.

Yuzhu Shi (Translation)

First of all, I think one thing to correct is in terms ofKing of Kings 1, the first game, we think it was a great game. It was very well-knownand quite popular, frankly speaking, in China at that time.

We admit that for King of Kings 2, it actually experiencedvery limited success. Part of the reason we are seeing, possibly due to thechange of development team members. In terms of King of Kings 3, this game wasessentially developed or conceptualized by the same team from King of Kings 1,whereby we actually are seeing a very great concept, also game play in thisgame. That’s why we paid attention to this King of Kings 3 and decided tobought all of the IP rights of this game.

C. Ming Zhao -Susquehanna

Thank you very much.

Operator

(Operator Instructions) Your next question comes from theline of Gerard Sullivan, American Century.

Jerry Sullivan -American Century

Thank you. I wonder if you could just back up a little bitfor me and talk about the -- both the change in the game rules that discouragegold farming, and I guess gold farming, by that you mean sort of anexperimental play or looking around of some kind, and why you did that and whythat is good for the long term. I’m just curious if it doesn’t discourageplayers to test the game and ultimately become payers. I just wanted someclarification on that. Thank you.

Eric He

Mr. Shi will answer the questions for you.

Yuzhu Shi (Translation)

First of all, it’s actually quite a prominent phenomena inChina. There are a lot of gold farming companies and they are pretty pervasive,actually existing in all kinds of games in China. We have actually seen greatdamage from this group of companies.

Especially in free-to-play type of games, their existenceactually generated artificially inflated supply in terms of the gold coin, orthe virtual currencies in games. That actually creates the inflation within thegame. So it’s actually for the benefit of the balance of the game, or for theplayer ability of the game to get rid of this group of undesirable targetgroup.

It is actually a common challenge facing almost all theonline games in China. We are possibly the most effective company inimplementing such a policy, especially in June. We have seen great results ingetting rid of or identifying this group of undesirable end users andsuccessfully reduce those numbers. So far, after the policy change or thechange of game rules, we have been continuously witnessing the increasing ACUand PCU numbers.

Eric He

Did we answer your question?

Jerry Sullivan -American Century

I’m sure you did, but I just wanted to maybe just for my ownclarification -- what does it mean? What does gold farming mean? Obviously it’san undesirable group. When you say they do damage, do they actually do sabotagedamage or is it just taking up space and room that other paying customers coulduse?

Yuzhu Shi (Translation)

Technically speaking, they don’t cause direct damage to theexisting players since they don’t actually get involved in the game play. Whatthose gold farming companies do is essentially they hire a bunch of people, itcould be hundreds or even thousands of people, just playing games with interactingwith other users to gain virtual currencies in-game and sell those currencieson the other website for real cash, which is RMB.

So in the short term, you may see those people actuallygenerating or creating virtual currency playing the game, while in the long runwith this group of people’s presence, they are actually reducing the economicbenefit for the game in the long run, since they are not actively the payingplayers. Secondly, it will create inflation within the game.

According to some unofficial statistics, we are seeing morethan 800,000 people engaging in gold farming activities.

Jerry Sullivan -American Century

All right. That’s great. Good answer. Thank you very much.

Eric He

Thanks. Next question, please.

Operator

Your next question comes from the line of George Chu fromUBS. Please proceed.

George Chu - UBS

(Translation not available) My question is on costs. On thegross margin for the last quarter, it was down slightly but still veryimpressive, and you mentioned the small decline is mostly due to spendingrelated to infrastructure. I would just like to know going forward, is thatstill going to have an impact in 4Q?

Also, in terms of the capitalization of costs for new games,what is the capitalized costs reflected in the cost of service in 4Q? This ismy first question.

Eric He

To answer your question, as you mentioned it very well,George, yes it is that we have been very proud to show our gross margin,although that the third quarter actually gross margin dipped a little bit butwe think it’s very healthy. Because what we have done is we actually made lotsof investments into the servers and also create a lot of the co-location, so weactually incurred a lot of the bandwidth costs. So all of that actually eatsinto the cost of services. That caused actually a little dip in the grossmargin. However, that is really very beneficial for the long-term developmentof the companies.

I think moving forward in the fourth quarter and the nextyear, at this moment, it is the company’s policy that we will give revenueguidance but in terms of the gross margin guidance, we are not in a position tomake a guidance or prediction at this moment. So for the time being, I cannotvery specifically answer the question on the fourth quarter gross marginquestion, so I have to apologize for that.

For the second part of your question is the capitalizedcosts and as you know, under U.S. GAAP, when our game becomes profitable, thecost of R&D will be capitalized. So that means until we start to collectmoney or revenue, that means a commercial launch. So during this period, allthe expenditures in terms of related to R&D will be capitalized. So this isunder the U.S. GAAP.

For Giant Online, in fact we started capitalization of ourR&D developments costs for Giant in January of this year and all the waythrough this quarter. So during this period, we actually capitalized close tomore than $1 million in terms of development costs for Giant Online.

But since from this quarter -- I’m sorry, from the fourthquarter, the capitalization will actually cease and moving forward, all theexpenditures related to Giant’s R&D expenses will be actually reported asR&D expenses moving forward.

George Chu - UBS

Right. That’s a great answer. Also, regarding the sales andmarketing liaison staff, you have 2,500 at the end of third quarter. Is there alonger term or a mid-term target to how much you grow that force to? And I haveone more follow-up question.

Eric He

That actually is related to our sales and marketing. I wouldlike to direct this question to Ms. Liu, our President, and I will do a littletranslation first.

Wei Liu (Translation)

First of all, as you can tell from the slide, from thesecond quarter to the third quarter, our liaison offices in our distributionnetwork has increased from 250 to 470, and our liaison personnel has increasedfrom 1,300 to 2,500. That is in preparation for the Giant closed beta testingwe are undergoing right now and also the first quarter of Giant's open betatesting.

And more importantly, that is also -- we are actuallypreparing for the expansion pack release of ZT Online in the fourth quarter. Weactually are pretty proud of successfully building up the network as we expect.Now the focus is really about the management and the training of the additionalpersonnel that we have hired to make them an effective member of the overallteam.

George Chu - UBS

Thank you. That’s clear. My last question is on the cost ofIPO as well as the employee bonus shares. I imagine these costs will bereflected in the 4Q results. Is that correct?

Eric He

I’m sorry, were you saying employment bonus share, meaningthe ESOP? Is that what it is?

George Chu - UBS

Yes, that’s what I mean, yes.

Eric He

Yes, in the fourth quarter actually, as you noted, this isthe IPO quarter so we will actually, according to U.S. GAAP, we will actuallycapitalize a lot of expenses into so-called IPO costs. Now we are finalizingthis process at this moment and also, upon IPO, we actually issued some of theESOP, so all of those will affect actually the fourth quarter P&L. So as weare talking right now, it’s affecting the fourth quarter income statementsalready. However, for the capitalization part of the IPO costs it actually isbeneficial in terms of the income statement because all of the expenses will becapitalized and treated as an asset.

George Chu - UBS

That’s great. Okay, that’s all my questions andcongratulations for very, very solid numbers. Thank you.

Operator

Your next question comes from the line of Alicia Yapp fromHong Kong.

Alicia Yapp -Citigroup

Good evening and good morning. I joined the call a littlebit late so I apologize if my question has already been answered. I have twoquestions. The first one, in terms of your future pipeline, what type games areyou interested to add? Will that stay in the same Chinese martial arts categoryor would you consider licensing some western style or Korean style games?

And then for your in-house development plans, are youdeveloping any other new games besides the Giant Online and ZT pay to play?

Wei Liu (Translation)

In terms of the company’s strategy, definitely we will befocusing on the self-developed games but at the same time, we actually are veryactive and also be open about licensing overseas successful games, especiallythose blockbuster type of games. We are actually open to both casual and alsoMMORPG type of games.

Our focus will be selecting those complementary type ofgames and also the games that fit or cater to Chinese players’ preferences. Soin terms of the licensing cost, our policy has always been trying to watch outfor the costs, not going to overpay for any game.

Alicia Yapp -Citigroup

Thank you. And then my second question is can you give usthe range of the average spend on ZT Online? You have a quarterly ARPU of aboutRMB305 and about RMB102 monthly. What is the highest amount spent by the topspender and will these top spenders continue to spend about the same amounteach month? Thank you.

Eric He

Let me clarify; when you say average what? I’m sorry, Ididn’t hear very clear, average?

Alicia Yapp -Citigroup

The average amount spent by the users on ZT Online.

Eric He

When you say average, you mean ARPU?

Alicia Yapp -Citigroup

Yes, the range -- for example, the highest amount and thelowest amount, because the ARPU is the average, right? So I would like to knowthe range from the lowest to the highest.

Yuzhu Shi (Translation)

Generally speaking, I have to say in ZT Online, thebeginning yes, there were quite a few users or players that are willing tospend a lot of money in playing this game, but more and more so with theintroduction of a lot of features and functions in place, we are seeing themedium spending user group actually taking a much larger percentage in terms ofthe total overall revenue contribution, and that’s a trend that we expect tocontinue to see.

Alicia Yapp -Citigroup

I see, and can I have one last question? With your 1.3million active paying accounts and your ARPU about RMB305, but then your gamingrevenue actually came in about $400 million. And your reported online gamingrevenue is about $404 million. Is this excluding the $1.2 million licensingrevenue? What is the difference? Can you help me understand a little bit?

Eric He

Let me answer the question for you. Maybe I think you aremisunderstanding what active paying accounts means. For active paying accounts,if you take active paying accounts 1.3 million times 305, that is not the rightequation to get your revenue numbers. It’s not because the definition of activepaying accounts means that during third quarter, for that player who actuallylogged on to our game and also at last paid for it, logged on once and paid forthe game, so that is an industry standard definition for active payingaccounts. So you cannot use that number to derive revenue. That is not acorrect equation to derive revenue.

So if you have the multiple of that result, it will actuallylead you to nowhere. So if you compare that -- so I don’t know what is thedifference of that, so I just want to clarify on the definition of activepaying accounts actually is that the paying player who actually logged on inthat particular quarter and at least paid for the game for at least once.

Alicia Yapp -Citigroup

Yes, I understand and because this quarter, you actuallydisclosed RMB305 is quarterly ARPU, right? But then on your prospectus, thisARPU, is it a monthly ARPU?

Eric He

No, it’s all quarterly. The last quarter was RMB295, thequarter before that was RMB320. It’s all quarterly numbers.

Alicia Yapp -Citigroup

Okay. All right, thank you.

Operator

Your next question comes from the line of [Defan Jian] fromCity Capital Assets Management. Please proceed.

Defan Jian - CityCapital Assets Management

(Translation not available) I have two questions. The firstquestion is about the performance of the ZT PTP online. I just want to know thecurrent ACU. And the second question is about the R&D team and theexpansion next year. Thank you.

Yuzhu Shi (Translation)

In terms of the ZT pay-to-play version, we actually hadfairly low expectations for the game, since our philosophy is really to focuson the free-to-play model. The purpose of having this pay-to-play version is toserve this niche market that we have identified and that we believe iscurrently underserved by our company.

So we are very happy to see that we actually -- theperformance of the game actually meets our expectations.

In terms of the R&D team, I am very excited about themorale and spirit I am seeing currently, even post IPO. As we speak, themajority of the R&D team people are actually staying back and workingcontinuously in the office.

In terms of R&D capabilities, I think one very importantaspect is really to keep the entrepreneurial spirit within the team, to give themthe constant motivation so that we can stay competitive.

Defan Jian - CityCapital Assets Management

Thank you. (Translation not available)

Yuzhu Shi (Translation)

We are recruiting good, new additional R&D people, so wehopefully by the end of next year, we can double our R&D team.

Eric He

Next question, please.

Operator

Your next question comes from the line of Charles Ho fromCAVA Capital. Please proceed.

Charles Ho - CAVACapital

Thank you for taking my call. Good evening, everybody. Myfirst question is can you give us the operating cash flow and capitalexpenditures number for the quarter?

Eric He

In terms of operating cash flow, because as you know, ouroperating cash flow in fact is larger than our net income, because we havedecided that on a quarterly basis, we will not disclose our operating cashflow. But I can answer your question in general. Our operating cash flowactually, because of the fact that we have deferred a portion of our revenues,our operating cash flow actually is greater than our net income and -- I’msorry, the first question was the operating cash flow and --

Charles Ho - CAVACapital

Capital expenditures.

Eric He

Our CapEx? Is that CapEx you asked? I’m sorry.

Charles Ho - CAVACapital

CapEx, yes, capital expenditures.

Eric He

Yes, as you know that it is very important for us to providea state-of-the-art service to the gamers, so we would like to constantlyimprove our service and that will really rely on our server replacement and ourinvestment in the servers.

So from IPO on, we will actually replace some of the oldergeneration servers that we used to buy two or three years ago. So I think interms of CapEx, moving forward we’ll be in the range of $30 million to $50million on an annual basis -- to purchase the servers and storage devices.

Charles Ho - CAVACapital

Thank you. My second question is since you already have likeRMB6 billion of cash, let me ask you, all your IPO proceeds, have you alreadyconverted them into RMB already, or they are still deposited in U.S. dollars?That’s the first part of my question.

The second part of the question is with so much cash, how doyou plan to spend it?

Eric He

The first question is the money that we have now, how do weallocate the money and the second part is how do we spend the money. I think Iwill direct the second part to our President, Ms. Liu.

For the first part of the question, let me address yourquestion at this moment. Because as you know, the IPO proceeds that we raised,we actually parked the money right now off-shore in the U.S., in U.S. accounts.It’s not been remitted [inaudible]. I think in the foreseeable future, we don’thave a plan to move that money on-shore into China. The reason is thatcurrently, as I mentioned, our operating cash flow has been very strong. Wehave about RMB1.2 billion on hand on-shore, that is in RMB accounts. So weactually have RMB1.2 billion on hand and the proceeds that we raised from theIPO off-shore.

So currently, I think we are keeping a very good balance interms of RMB exposure and U.S. dollars exposure.

For the second part of your question, I will direct that toMs. Liu.

Wei Liu

(Translation not available)

Charles Ho - CAVACapital

Thank you. Eric, I want to follow-up on your cashallocation, or whatever it’s called. Do you realize that the U.S. dollar is ona depreciation trend? To me, it doesn’t make sense that you keep a huge part ofthe money in U.S. dollars in a U.S. account, because it’s depreciating.

Eric He

That’s a great question, Charles. Let me tell you this; weare very conscious about what you worry. In fact, we will -- first of all, wewill put that money into cash equivalent accounts, so we will not actually putthat into so-called investment accounts.

In order to do that, we will actually try to ask the bank tohelp us to hedge the risk against appreciation of RMB because our reportingcurrency actually is RMB, and so that is already in the way. But I have to tellyou that we will not do any risky investments. We will put that into a veryliquid account and to hedge the risk or exposure of appreciation of RMB.

Charles Ho - CAVACapital

Can you elaborate a little bit on the specific hedgingtechnique that can be used?

Eric He

At this point, I can only tell you that we will not dealwith future options and that sort of thing. We will not. We will not touch thatkind of thing but only to tell you that we will put it into a cash and cashequivalent account in a very safe deposit. So that’s all I can report to youbecause we are in the process of reviewing all the options at this moment.

Charles Ho - CAVACapital

That’s good, but actually I just want to say again that Ithink the U.S. dollar, it looks like it’s on secular depreciation trend, so Iwould like the company to have a way to preserve its worth in this huge amountof money.

Eric He

Your viewpoint is fully appreciated by ours, and so yes, weunderstand exactly what you mean. We will be very cautious and conscious onthis viewpoint.

Charles Ho - CAVACapital

Thank you. Then my next question is a follow-up on yourcapping basically the amount of money that players can pay to RMB15 to RMB30per week, right, depending on the experience level on your Giant Online. Andyou have explained that [inaudible], you expected to have good revenue becauseyou expected to have much more paying customers or players. So can you give methe reason why -- why is it that you can expect Giant Online to have much morepaying players compared to ZT Online?

Eric He

I would like to direct this question to Ms. Liu. I willtranslate that; if I understand this question correctly, it’s like this. Okay,Mr. Shi will answer your question.

Yuzhu Shi (Translation)

First of all, in China’s online gaming industry, we areactually seeing great change in terms of the landscape or the viewpoint, theschool of thought, so we need to adapt our thinking.

One thing we observed is Korean developers, their gamesdevelopment capabilities are improving so the games coming to China actuallyare having or exhibiting better quality. However, in terms of users’ adoption,we are actually seeing a decreasing trend.

We actually did a study behind the users’ preference changeand their school of thought and their viewpoints towards online games and thatis the fundamental or the cornerstone of how we come up with Giant Online. Fromour initial closed beta testing results, we actually are expecting the revenuefrom Giant Online will be at least no less than the ZT Online game. This is adirect result of the change in terms of users’ spending behavior and also theirplaying behavior.

For Giant, we actually see, as you have pointed out, thepercentage of paying players increase and also the willingness to spend onbehalf of their friends is also increasing.

Eric He

Okay, next question. No more?

Operator

At this time, I am showing you have no more questions. Iwould like to now turn the call back over to Mr. Eric He. Please proceed, sir.

Eric He

Thank you again for joining us today and we look forward toupdating you on our progress in the near future. Thank you, everyone.

Operator

Thank you for your participation in today’s conference. Thisconcludes the presentation and you may now disconnect. Have a good day.

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